Earlier this week, Joe Nocera wrote a puff piece on Karen Petrou of Federal Financial Analytics. In the piece, Nocera and Petrou repeat a frequently-heard — but nevertheless exceedingly superficial — argument that has always bothered me. From Nocera’s NYT column:

[Petrou] also points to a contradiction in the way the Too Big to Fail institutions are being dealt with. On the one hand, Dodd-Frank is very clear that if a big bank becomes insolvent, there can be no taxpayer bailout. It must be wound down, just like any other bank. Yet, at the same time, she says, the federal and international regulators are adding a host of special Too Big to Fail capital requirements and rules. “They are acting as if these institutions are still too big to fail. The two thrusts are incompatible.”

Oy. This is not a contradiction. Applying additional capital requirements and more stringent regulations to certain large financial institutions is absolutely not incompatible with ending Too Big to Fail — or with Dodd-Frank’s new resolution authority for large financial institutions.

The new resolution authority makes is easier for large financial institutions (known as SIFIs) to fail, which is the exact opposite of “acting as if these institutions are still too big to fail.” Moreover, the additional capital requirements and regulations for SIFIs in no way contradict the resolution authority. The purpose of the additional capital requirements and enhanced prudential regulations for SIFIs is to make it less likely that a SIFI will fail. The purpose of the resolution authority is to make sure that when a SIFI fails, it can do so without bringing down the entire financial system. These are not contradictory — they’re complementary.

These are pretty basic concepts of financial reform — I wrote a post way back in October 2009, before Congress even took up the financial reform bill, explaining how a SIFI regime and a new resolution authority would fit together. The fact that so many financially-focused pundits have yet to move beyond the “hey, if they’re ‘systemically important’ they must be TBTF!”-level of analysis is just sad.

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comments:

Excellent post and blog -- thank you. This exact same Nocera paragraph left me scratching my head as well. You point is well taken that the recent crop of regulations aimed at systemically important institutions are in theory designed to make failure less likely; they may also (by raising the cost of engaging in certain types of business) encourage the SI Too Complex To Fail financial services companies to exit or divest some of their businesses.

You know something is working when TCTFs start reporting ROEs dropping from 30% to 5%. Hmmm, deleveraging anyone?

"the additional capital requirements and regulations for SIFIs . . . The purpose of the additional capital requirements and enhanced prudential regulations for SIFIs is to make it less likely that a SIFI will fail. The purpose of the resolution authority is to make sure that when a SIFI fails, it can do so without bringing down the entire financial system. These are not contradictory — they’re complementary."

I'm not going to defend Nocera's peculiar brand of fuzzy thinking in a column he clearly hacked out, but I see a contradiction, or two or three.

The major one is between wanting the banking industry (and financial sector generally) to become profitable and solvent, on the one hand, and wanting the financial sector to become less predatory and toxic to the global economy, on the other.

Increasing capital requirements is a lovely thought, but it entails paying a return on that capital, which, in turn, entails exploiting some economic rent in the operation of financial businesses. The big five, six or seven financial institutions in the U.S. enjoy an economic rent from sheer size and power, and the special claims on gov't backing that come with size and systemic importance. Unfortunately, these advantages are offset by considerable diseconomies of scope, and now also the diseconomies of special requirements imposed under D-F.

Most of Nocera's column is about the bewildering complexity of the rule-making. There's a basic contradiction between the neoliberal vision of a principles-based supervision aimed at improving executive governance (transparency! integrity!) and the kind of rules-based, financial repression, which might actually reduce the burden of financial predation, and with it the scope for banking profits, and which would require breaking up the giant, universal banks into much smaller, strategically diverse and economically efficient units.

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I'm a finance lawyer in New York. I used to focus on derivatives and structured finance (you know, back when there was a structured finance market). I spent the majority of my career at one of the major investment banks. My background is in economics and, unfortunately, politics.

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